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Saturday, November 24, 2012

Chairman Ben S. Bernanke At the New York Economic Club, New York, New York

Chairman Ben S. Bernanke

At the New York Economic Club, New York, New York

November 20, 2012

The Economic Recovery and Economic Policy

Good afternoon. I am pleased to join the New York Economic Club
for lunch today. I know that many of you and your friends and neighbors
are still recovering from the effects of Hurricane Sandy, and I want to
let you know that our thoughts are with everyone who has suffered during
the storm and its aftermath.

My remarks today will focus on the reasons for the
disappointingly slow pace of economic recovery in the United States and
the policy actions that have been taken by the Federal Open Market
Committee (FOMC) to support the economy. In addition, I will discuss
some important economic challenges our country faces as we close out
2012 and move into 2013--in particular, the challenge of putting federal
government finances on a sustainable path in the longer run while
avoiding actions that would endanger the economic recovery in the near
term.

The Recovery from the Financial Crisis and Recession

The economy has continued to recover from the financial crisis
and recession, but the pace of recovery has been slower than FOMC
participants and many others had hoped or anticipated when I spoke here
about three years ago. Indeed, since the recession trough in mid-2009,
growth in real gross domestic product (GDP) has averaged only a little
more than 2 percent per year.

Similarly, the job market has improved over the past three years,
but at a slow pace. The unemployment rate, which peaked at 10 percent
in the fall of 2009, has since come down 2 percentage points to just
below 8 percent. This decline is obviously welcome, but it has taken a
long time to achieve that progress, and the unemployment rate is still
well above both its level prior to the onset of the recession and the
level that my colleagues and I think can be sustained once a full
recovery has been achieved. Moreover, many other features of the jobs
market, including the historically high level of long-term unemployment,
the large number of people working part time because they have not been
able to find full-time jobs, and the decline in labor force
participation, reinforce the conclusion that we have some way to go
before the labor market can be deemed healthy again.

Meanwhile, inflation has generally remained subdued. As is often
the case, inflation has been pushed up and down in recent years by
fluctuations in the price of crude oil and other globally traded
commodities, including the increase in farm prices brought on by this
summer's drought. But with longer-term inflation expectations remaining
stable, the ebbs and flows in commodity prices have had only transitory
effects on inflation. Indeed, since the recovery began about three years
ago, consumer price inflation, as measured by the personal consumption
expenditures (PCE) price index, has averaged almost exactly 2 percent,
which is the FOMC's longer-run objective for inflation.1
Because ongoing slack in labor and product markets should continue to
restrain wage and price increases, and with the public's inflation
expectations continuing to be well anchored, inflation over the next few
years is likely to remain close to or a little below the Committee's
objective.

As background for our monetary policy decisionmaking, we at the
Federal Reserve have spent a good deal of effort attempting to
understand the reasons why the economic recovery has not been stronger.
Studies of previous financial crises provide one helpful place to start.2
This literature has found that severe financial crises--particularly
those associated with housing booms and busts--have often been
associated with many years of subsequent weak performance. While this
result allows for many interpretations, one possibility is that
financial crises, or the deep recessions that typically accompany them,
may reduce an economy's potential growth rate, at least for a time.

The accumulating evidence does appear consistent with the
financial crisis and the associated recession having reduced the
potential growth rate of our economy somewhat during the past few years.
In particular, slower growth of potential output would help explain why
the unemployment rate has declined in the face of the relatively modest
output gains we have seen during the recovery. Output normally has to
increase at about its longer-term trend just to create enough jobs to
absorb new entrants to the labor market, and faster-than-trend growth is
usually needed to reduce unemployment. So the fact that unemployment
has declined in recent years despite economic growth at about 2 percent
suggests that the growth rate of potential output must have recently
been lower than the roughly 2-1/2 percent rate that appeared to be in
place before the crisis.3

There are a number of ways in which the financial crisis could
have slowed the rate of growth of the economy's potential. For example,
the extraordinarily severe job losses that followed the crisis,
especially in housing-related industries, may have exacerbated for a
time the extent of mismatch between the jobs available and the skills
and locations of the unemployed. Meanwhile, the very high level of
long-term unemployment has probably led to some loss of skills and labor
force attachment among those workers. These factors may have pushed up
to some degree the so-called natural rate of unemployment--the rate of
unemployment that can be sustained under normal conditions--and reduced
labor force participation as well. The pace of productivity
gains--another key determinant of growth in potential output--may also
have been restrained by the crisis, as business investment declined
sharply during the recession; and increases in risk aversion and
uncertainty, together with tight credit conditions, may have impeded the
commercial application of new technologies and slowed the pace of
business formation.

Importantly, however, although the nation's potential output may
have grown more slowly than expected in recent years, this slowing seems
at best a partial explanation of the disappointing pace of the economic
recovery. In particular, even though the natural rate of unemployment
may have increased somewhat, a variety of evidence suggests that any
such increase has been modest, and that substantial slack remains in the
labor market. For example, the slow pace of employment growth has been
widespread across industries and regions of the country. That pattern
suggests a broad-based shortfall in demand rather than a substantial
increase in mismatch between available jobs and workers, because greater
mismatch would imply that the demand for workers would be strong in
some regions and industries, not weak almost across the board. Likewise,
if a mismatch of jobs and workers is the predominant problem, we would
expect to see wage pressures developing in those regions and industries
where labor demand is strong; in fact, wage gains have been quite
subdued in most industries and parts of the country.4
Indeed, as I indicated earlier, the consensus among my colleagues on
the FOMC is that the unemployment rate is still well above its
longer-run sustainable level, perhaps by 2 to 2-1/2 percentage points or
so.5

A critical question, then, is why significant slack in the job
market remains three years after the recovery began. A likely
explanation, which I will discuss further, is that the economy has been
faced with a variety of headwinds that have hindered what otherwise
might have been a stronger cyclical rebound. If so, we may take some
encouragement from the likelihood that there are potentially two sources
of faster GDP growth in the future. First, the effects of the crisis on
potential output should fade as the economy continues to heal.6
And second, if the headwinds begin to dissipate, as I expect, growth
should pick up further as many who are currently unemployed or out of
the labor force find work.

Headwinds Affecting the Recovery

What are the headwinds that have slowed the return of our economy
to full employment? Some have come from the housing sector. Previous
recoveries have often been associated with a vigorous rebound in
housing, as rising incomes and confidence and, often, a decline in
mortgage interest rates led to sharp increases in the demand for homes.7
But the housing bubble and its aftermath have made this episode quite
different. In the first half of the past decade, both housing prices and
construction rose to what proved to be unsustainable levels, leading to
a subsequent collapse: House prices declined almost one-third
nationally from 2006 until early this year, construction of
single-family homes fell two-thirds, and the number of construction jobs
decreased by nearly one-third. And, of course, the associated surge in
delinquencies on mortgages helped trigger the broader financial crisis.

Recently, the housing market has shown some clear signs of
improvement, as home sales, prices, and construction have all moved up
since early this year. These developments are encouraging, and it seems
likely that, on net, residential investment will be a source of economic
growth and new jobs over the next couple of years. However, while
historically low mortgage interest rates and the drop in home prices
have made housing exceptionally affordable, a number of factors continue
to prevent the sort of powerful housing recovery that has typically
occurred in the past. Notably, lenders have maintained tight terms and
conditions on mortgage loans, even for potential borrowers with
relatively good credit.8
Lenders cite a number of factors affecting their decisions to extend
credit, including ongoing uncertainties about the course of the economy,
the housing market, and the regulatory environment. Unfortunately,
while some tightening of the terms of mortgage credit was certainly an
appropriate response to the earlier excesses, the pendulum appears to
have swung too far, restraining the pace of recovery in the housing
sector.

Other factors slowing the recovery in housing include the fact
that many people remain unable to buy homes despite low mortgage rates;
for example, about 20 percent of existing mortgage borrowers owe more on
their mortgages than their houses are worth, making it more difficult
for them to refinance or sell their homes. Also, a substantial overhang
of vacant homes, either for sale or in the foreclosure pipeline,
continues to hold down house prices and reduce the need for new
construction. While these headwinds on both the supply and demand sides
of the housing market have clearly started to abate, the recovery in the
housing sector is likely to remain moderate by historical standards.

A second set of headwinds stems from the financial conditions
facing potential borrowers in credit and capital markets. After the
financial system seized up in late 2008 and early 2009, global economic
activity contracted sharply, and credit and capital markets suffered
significant damage. Although dramatic actions by governments and central
banks around the world helped these markets to stabilize and begin
recovering, tight credit and a high degree of risk aversion have
restrained economic growth in the United States and in other countries
as well.

Measures of the condition of U.S. financial markets and
institutions suggest gradual but significant progress has been achieved
since the crisis. For example, credit spreads on corporate bonds and
syndicated loans have narrowed considerably, and equity prices have
recovered most of their losses. In addition, indicators of market stress
and illiquidity--such as spreads in short-term funding markets--have
generally returned to levels near those seen before the crisis. One
gauge of the overall improvement in financial markets is the National
Financial Conditions Index maintained by the Federal Reserve Bank of
Chicago. The index shows that financial conditions, viewed as a whole,
are now about as accommodative as they were in the spring of 2007.

In spite of this broad improvement, the harm inflicted by the
financial crisis has yet to be fully repaired in important segments of
the financial sector. One example is the continued weakness in some
categories of bank lending. Banks' capital positions and overall asset
quality have improved substantially over the past several years, and,
over time, these balance sheet improvements will position banks to
extend considerably more credit to bank-dependent borrowers. Indeed,
some types of bank credit, such as commercial and industrial loans, have
expanded notably in recent quarters. Nonetheless, banks have been
conservative in extending loans to many consumers and some businesses,
likely even beyond the restrictions on the supply of mortgage lending
that I noted earlier. This caution in lending by banks reflects, among
other factors, their continued desire to guard against the risks of
further economic weakness.

A prominent risk at present--and a major source of financial
headwinds over the past couple of years--is the fiscal and financial
situation in Europe. This situation, of course, was not anticipated when
the U.S. recovery began in 2009. The elevated levels of stress in
European economies and uncertainty about how the problems there will be
resolved are adding to the risks that U.S. financial institutions,
businesses, and households must consider when making lending and
investment decisions. Negative sentiment regarding Europe appears to
have weighed on U.S. equity prices and prevented U.S. credit spreads
from narrowing even further. Weaker economic conditions in Europe and
other parts of the world have also weighed on U.S. exports and corporate
earnings.

Policymakers in Europe have taken some important steps recently,
and in doing so have contributed to some welcome easing of financial
conditions. In particular, the European Central Bank's new Outright
Monetary Transactions program, under which it could purchase the
sovereign debt of vulnerable euro-area countries who agree to meet
prescribed conditions, has helped ease market concerns about those
countries. European governments have also taken steps to strengthen
their financial firewalls and to move toward greater fiscal and banking
union. Further improvement in global financial conditions will depend in
part on the extent to which European policymakers follow through on
these initiatives.

A third headwind to the recovery--and one that may intensify in
force in coming quarters--is U.S. fiscal policy. Although fiscal policy
at the federal level was quite expansionary during the recession and
early in the recovery, as the recovery proceeded, the support provided
for the economy by federal fiscal actions was increasingly offset by the
adverse effects of tight budget conditions for state and local
governments. In response to a large and sustained decline in their tax
revenues, state and local governments have cut about 600,000 jobs on net
since the third quarter of 2008 while reducing real expenditures for
infrastructure projects by 20 percent.

More recently, the situation has to some extent reversed: The
drag on economic growth from state and local fiscal policy has
diminished as revenues have improved, easing the pressures for further
spending cuts or tax increases. In contrast, the phasing-out of earlier
stimulus programs and policy actions to reduce the federal budget
deficit have led federal fiscal policy to begin restraining GDP growth.
Indeed, under almost any plausible scenario, next year the drag from
federal fiscal policy on GDP growth will outweigh the positive effects
on growth from fiscal expansion at the state and local level. However,
the overall effect of federal fiscal policy on the economy, both in the
near term and in the longer run, remains quite uncertain and depends on
how policymakers meet two daunting fiscal challenges--one by the start
of the new year and the other no later than the spring.

Upcoming Fiscal Challenges

What are these looming challenges? First, the Congress and the
Administration will need to protect the economy from the full brunt of
the severe fiscal tightening at the beginning of next year that is built
into current law--the so-called fiscal cliff. The realization of all of
the automatic tax increases and spending cuts that make up the fiscal
cliff, absent offsetting changes, would pose a substantial threat to the
recovery--indeed, by the reckoning of the Congressional Budget Office
(CBO) and that of many outside observers, a fiscal shock of that size
would send the economy toppling back into recession. Second, early in
the new year it will be necessary to approve an increase in the federal
debt limit to avoid any possibility of a catastrophic default on the
nation's Treasury securities and other obligations. As you will recall,
the threat of default in the summer of 2011 fueled economic uncertainty
and badly damaged confidence, even though an agreement ultimately was
reached. A failure to reach a timely agreement this time around could
impose even heavier economic and financial costs.

As fiscal policymakers face these critical decisions, they should
keep two objectives in mind. First, as I think is widely appreciated by
now, the federal budget is on an unsustainable path. The budget
deficit, which peaked at about 10 percent of GDP in 2009 and now stands
at about 7 percent of GDP, is expected to narrow further in the coming
years as the economy continues to recover. However, the CBO projects
that, under a plausible set of policy assumptions, the budget deficit
would still be greater than 4 percent of GDP in 2018, assuming the
economy has returned to its potential by then. Moreover, under the CBO
projection, the deficit and the ratio of federal debt to GDP would
subsequently return to an upward trend.9
Of course, we should all understand that long-term projections of
ever-increasing deficits will never actually come to pass, because the
willingness of lenders to continue to fund the government can only be
sustained by responsible fiscal plans and actions. A credible framework
to set federal fiscal policy on a stable path--for example, one on which
the ratio of federal debt to GDP eventually stabilizes or declines--is
thus urgently needed to ensure longer-term economic growth and
stability.

Even as fiscal policymakers address the urgent issue of
longer-run fiscal sustainability, they should not ignore a second key
objective: to avoid unnecessarily adding to the headwinds that are
already holding back the economic recovery. Fortunately, the two
objectives are fully compatible and mutually reinforcing. Preventing a
sudden and severe contraction in fiscal policy early next year will
support the transition of the economy back to full employment; a
stronger economy will in turn reduce the deficit and contribute to
achieving long-term fiscal sustainability. At the same time, a credible
plan to put the federal budget on a path that will be sustainable in the
long run could help keep longer-term interest rates low and boost
household and business confidence, thereby supporting economic growth
today.

Coming together to find fiscal solutions will not be easy, but
the stakes are high. Uncertainty about how the fiscal cliff, the raising
of the debt limit, and the longer-term budget situation will be
addressed appears already to be affecting private spending and
investment decisions and may be contributing to an increased sense of
caution in financial markets, with adverse effects on the economy.
Continuing to push off difficult policy choices will only prolong and
intensify these uncertainties. Moreover, while the details of whatever
agreement is reached to resolve the fiscal cliff are important, the
economic confidence of both market participants and the general public
likely will also be influenced by the extent to which our political
system proves able to deliver a reasonable solution with a minimum of
uncertainty and delay. Finding long-term solutions that can win
sufficient political support to be enacted may take some time, but
meaningful progress toward this end can be achieved now if policymakers
are willing to think creatively and work together constructively.

Monetary Policy

Let me now turn briefly to monetary policy.

Monetary policy can do little to reverse the effects that the
financial crisis may have had on the economy's productive potential.
However, it has been able to provide an important offset to the
headwinds that have slowed the cyclical recovery. As you know, the
Federal Reserve took strong easing measures during the financial crisis
and recession, cutting its target for the federal funds rate--the
traditional tool of monetary policy--to nearly zero by the end of 2008.
Since that time, we have provided additional accommodation through two
nontraditional policy tools aimed at putting downward pressure on
longer-term interest rates: asset purchases that reduce the supply of
longer-term securities outstanding in the market, and communication
about the future path of monetary policy.

Most recently, after the September FOMC meeting, we announced
that the Federal Reserve would purchase additional agency
mortgage-backed securities (MBS) and continue with the program to extend
the maturity of our Treasury holdings.10
These additional asset purchases should put downward pressure on
longer-term interest rates and make broader financial conditions more
accommodative.11
Moreover, our purchases of MBS, by bringing down mortgage rates,
provide support directly to housing and thereby help mitigate some of
the headwinds facing that sector. In announcing this decision, we also
indicated that we would continue purchasing MBS, undertake additional
purchases of longer-term securities, and employ our other policy tools
until we judge that the outlook for the labor market has improved
substantially in a context of price stability.

Although it is still too early to assess the full effects of our
most recent policy actions, yields on corporate bonds and agency MBS
have fallen significantly, on balance, since the FOMC's announcement.
More generally, research suggests that our previous asset purchases have
eased overall financial conditions and provided meaningful support to
the economic recovery in recent years.12

In addition to announcing new purchases of MBS, at our September
meeting we extended our guidance for how long we expect that
exceptionally low levels for the federal funds rate will likely be
warranted at least through the middle of 2015. By pushing the expected
period of low rates further into the future, we are not saying that we
expect the economy to remain weak until mid-2015; rather, we expect--as
we indicated in our September statement--that a highly accommodative
stance of monetary policy will remain appropriate for a considerable
time after the economic recovery strengthens.13
In other words, we will want to be sure that the recovery is
established before we begin to normalize policy. We hope that such
assurances will reduce uncertainty and increase confidence among
households and businesses, thereby providing additional support for
economic growth and job creation.

Conclusion

In sum, the U.S. economy continues to be hampered by the
lingering effects of the financial crisis on its productive potential
and by a number of headwinds that have hindered the normal cyclical
adjustment of the economy. The Federal Reserve is doing its part by
providing accommodative monetary policy to promote a stronger economic
recovery in a context of price stability. As I have said before,
however, while monetary policy can help support the economic recovery,
it is by no means a panacea for our economic ills. Currently,
uncertainties about the situation in Europe and especially about the
prospects for federal fiscal policy seem to be weighing on the spending
decisions of households and businesses as well as on financial
conditions. Such uncertainties will only be increased by discord and
delay. In contrast, cooperation and creativity to deliver fiscal
clarity--in particular, a plan for resolving the nation's longer-term
budgetary issues without harming the recovery--could help make the new
year a very good one for the American economy.

1. Inflation excluding food and energy has averaged a little less, about 1-1/2 percent, over this period. Return to text

3. That said, GDP growth in excess of
potential is probably not the whole explanation for the decline in
unemployment. Some of the decline in unemployment during the recovery
could also reflect a reversal of the especially large increases that
occurred during the deepest part of the recession, when firms appeared
to cut their workforces by greater numbers than would normally be
associated with the decline in GDP. (For a discussion, see Ben S.
Bernanke (2012), "Recent Developments in the Labor Market,"
speech delivered at the National Association for Business Economics
28th Annual Economic Policy Conference, Arlington, Va., March 26.) A
reduction in the number of people receiving extended or emergency
unemployment insurance benefits may have contributed to the decline in
unemployment as well. Return to text

4. In addition, while the changing
relationship between job vacancies and unemployment--the shift in the
Beveridge curve--probably does point to some greater difficulty matching
jobs with workers, factors other than mismatch likely explain some of
that shift. For example, evidence suggests that firms tend to become
more selective in hiring when their hiring needs are not urgent. For
further discussion of these labor market issues, see Bernanke, "Recent
Developments," in note 3 and the references cited therein. See also
Edward P. Lazear and James R. Spletzer (2012), "The United States Labor Market: Status Quo or a New Normal? (PDF)"
paper delivered at "The Changing Policy Landscape," a symposium
sponsored by the Federal Reserve Bank of Kansas City, held in Jackson
Hole, Wyo., August 30-September 1. Return to text

5. In the September 2012 Summary of
Economic Projections (SEP), the central tendency of FOMC participants'
estimates of the long-run normal rate of unemployment ranged from 5.2 to
6 percent. The SEP is an addendum to the FOMC minutes and is available
at Board of Governors of the Federal Reserve System (2012), "Minutes of the Federal Open Market Committee, September 12-13, 2012," press release, October 4. Return to text

6. For example, mismatch problems in
the labor market should fade as the economy strengthens, a further rise
in business investment would contribute to faster growth in the capital
stock, and an improving economy should cause investors to become less
risk averse. Return to text

7. In the recoveries following the
1975 and 1982 recessions, for example, residential construction directly
contributed about 1 percentage point to GDP growth during the two years
following the recession trough; indirect effects--through the effect of
home prices on consumer spending or through multiplier effects--no
doubt added to the contribution. Return to text

8. For example, according to the April
2012 Senior Loan Officer Opinion Survey on Bank Lending, about one-half
of lenders reported that they were "somewhat less likely" or "much less
likely" than in 2006 to originate a mortgage to a borrower with a FICO
score of 680 and a 10 percent down payment. The complete survey is
available on the Board's website. Return to text

11. One way in which our asset
purchases affect the economy is through the so-called portfolio balance
channel. Because different classes of financial assets are not perfect
substitutes in investors' portfolios, changes in the supplies of various
assets available to private investors may affect the prices and yields
of those assets. Thus, the Federal Reserve's purchases of Treasury
securities, for example, should raise the prices and lower the yields of
those securities; moreover, as investors rebalance their portfolios by
replacing the Treasury securities sold to the Federal Reserve with other
assets, the prices of those other assets should rise and their yields
decline as well. An increase in our asset purchases may also act as a
signal that we intend to pursue a persistently more accommodative policy
stance than previously thought, thereby lowering investors'
expectations for the future path of the federal funds rate and putting
additional downward pressure on longer-term interest rates. Return to text